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    Compensating Key Employees of Small and Mid-size Businesses

    Employers must find creative and effective ways to keep and motivate top employees, which can be especially challenging during an economic downturn when bonus dollars may be tight. Here are some practical methods – and their compensation compliance issues – that attorneys can discuss with the business clients.

    Michael G. May

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    Wisconsin LawyerWisconsin Lawyer
    Vol. 82, No. 6, June 2009

    Carrot and Stick 

    Are your business clients worried about losing key employees to competitors? If so, they are not alone. In a 2008 study sponsored by Deloitte Consulting LLP and the International Society of Certified Employee Benefit Specialists, 54 percent of respondents (representing a diverse cross-section of U.S.-based employers) viewed “talent management” as their top organizational challenge – even more important than the rising cost of health care benefits. At the same time, employers expect more each year from already productive employees – nearly 70 percent of the surveyed companies declared an intent to increase emphasis on performance-based compensation plans. When combined, these trends present a challenge for lawyers because the trends’ emergence has been accompanied by Enron-inspired federal regulation of key-employee compensation.

    This article discusses methods, and their associated compliance issues, to keep and motivate top employees of small and mid-size companies. In an economic downturn, the ability to provide counsel on these matters can have an immediate bottom-line impact on business clients. For example, certain compensation techniques can: 1) give the employer an income tax deduction without a corresponding cash outlay; 2) make compensation contingent on attaining specific business objectives; 3) require reimbursement of compensation to the employer if an employee joins a competitor; 4) realign payrolls to favor employees whose services are most important to the business; and 5) defer bonus or incentive payments to key employees to accumulate liquid employer funds and maintain morale among other workers.

    Bonus Plans

    The simplest method to reward top employees is to pay a cash bonus built around a business owner’s current or long-term objectives. Variations of these plans are limited only by the employer’s creativity. In crafting a bonus plan, it is important to provide an objective and clear standard that all parties understand, perhaps based on profits, sales, or another priority item from the client’s business plan. The standard even could include multiple tests, each assigned a different weight, to measure and reward more than one business priority. As with any current compensation, a cash bonus is income to the employee under section 61 of the Internal Revenue Code (IRC) and is deductible to the employer under section 162 to the extent it is reasonable.

    A bonus plan also can provide an employee with property, such as a business-owned financial asset or an ownership stake in the business. This can be particularly effective as a means of transferring shares or units in the business to an employee who might later want to buy the remaining shares or units from the current owner. A transfer of property is more complex than a cash bonus but offers additional tax choices and may appeal to companies when cash is scarce or credit is not available. Generally, the fair market value of the transferred property is taxable to the employee and deductible to the employer at the time of transfer.

    Under the I.R.C. § 83 rules governing the tax treatment of property-based compensation, a transfer can be made subject to a “substantial risk of forfeiture,” commonly referred to as a vesting schedule, which requires an employee to provide substantial services or meet performance criteria before having the right to keep the property. The use of a vesting schedule generally defers the taxability to the employee of the property (including posttransfer appreciation) until it is vested and delays the employer’s deduction until then. An exception to this rule allows the employee to elect to be taxed in the year of transfer under I.R.C. § 83(b). This exception has the dual advantages of delaying tax on later appreciation until the property is sold and converting tax on the appreciation from ordinary income to capital gain. Of course, the election is also a gamble because the property could decrease in value or never vest at all.

    Michael G. May

    Michael G. May, U.W. 1990, operates a sole practice in Glendale, with an emphasis on business and estate planning. He can be reached at net mike mikemaylaw mikemaylaw mike net.

    Example: Employee A and Employee B each receive $10,000 of employer stock in lieu of cash compensation in 2009. The stock vests at the end of five years, at which time it is worth $15,000. Employee A recognizes $15,000 of ordinary income in 2014 (year 5) and the employee takes a corresponding income tax deduction. Employee B makes an I.R.C. § 83(b) election and recognizes $10,000 of ordinary income in 2009 (the year the employee receives the stock); the employer deducts $10,000 in 2009. The $5,000 of appreciation, along with any later appreciation, is taxed to Employee B as capital gain when the stock is sold.

    If a bonus plan transfers an interest in the business or other hard-to-value property to the employee, an appraisal will likely be required to substantiate the amount of reportable income. In addition, a sole owner will assume new legal obligations (such as opening company books for inspection) when adding minority owners and should expect to pay higher legal and accounting costs. These disadvantages might not matter, however, if the appraisal can be used for other purposes, such as the current owner’s estate planning, or if the employee already has access to financial information from the business.

    As long as a right to a bonus payment may be reduced unilaterally or eliminated by the employer after the employee has performed the services, the onerous deferred-compensation rules described below will not apply. Further, any plan that requires an individual to be employed as a condition for receiving payments (for example, an annual fixed or variable payment promised to managers who are employed full-time when the bonus is payable) generally is not subject to those rules if payment must be made within two-and-a-half months after the end of the taxable year in which the condition is satisfied. Depending on how it is structured, a bonus plan may require a claims procedure, the naming of a plan fiduciary, and compliance with other provisions under the Employee Retirement Income Security Act of 1974 (ERISA).

    Deferred Compensation Plans

    The qualified retirement plan no longer serves as an effective retention or motivational tool for many top employees. For tax purposes, a qualified retirement plan generally is one that meets the requirements of I.R.C. § 401. Although the contribution limits under these plans (currently $49,000 for defined-contribution arrangements such as profit-sharing plans) and the inability to discriminate in favor of top employees often are cited as shortcomings, the vesting restrictions under qualified retirement plans are the real culprit. Since the enactment of ERISA, the federal government has gradually reduced the 10-year cliff vesting schedule to three years and the five- to 15-year phased vesting schedule to two to six years. These rigid vesting requirements, which apply to all defined contribution plans and to any plan that is “top-heavy” with respect to key employees, prohibit employers from combining generous, tax-deferred compensation with time- or performance-based vesting designed to make the business more profitable. Consequently, the qualified plan may do little to motivate the employer or affect the behavior of the employee, for whom the benefit is an expectation instead of a special incentive.

    Enter the world of non-qualified deferred compensation. A non-qualified deferred compensation plan generally is defined in the negative as one that does not meet the requirements of a qualified retirement plan. Under tax and labor laws, employers can provide deferred compensation to key employees on a discriminatory basis, provided that the arrangement is maintained primarily for the purpose of providing payments for a select group of management or highly compensated employees. Employer contributions under these plans are deducted by the employer when the payments are made and correspond (in timing and amount) to what the employee reports in income. Because these plans are exempt from the contribution and vesting restrictions of qualified retirement plans, they remain a powerful tool for employers seeking to hire, keep, and create performance incentives for the company’s most valued workers. Any type or size of business can offer one, but because the employee is an unsecured creditor with respect to the benefit, these plans should be used only by companies that are expected to be solvent when payments are made. The employer must make a one-time disclosure to the Department of Labor to be exempt from most of the ERISA requirements that otherwise apply to retirement plans.

    Until recently, the non-qualified deferred compensation tax requirements reflected a patchwork of court decisions and Internal Revenue Service rulings dating to the 1960s. The rules are now expanded and codified under I.R.C. § 409A, which became effective on Jan. 1, 2005, and its corresponding regulations, which became effective on Jan. 1, 2009. While the economics of non-qualified deferred compensation have not changed, the consequences of failing to comply with the rules have become more severe. Violating section 409A has the threefold risk of accelerating income taxes on the deferred amount, subjecting the amount to interest, and triggering a 20-percent penalty. Adding insult to injury, the taxes, interest, and penalty must be paid by the employee, who may have no involvement in the plan’s administration. In short, these plans, which often were informal in the past, now require careful drafting and ongoing supervision, making them appropriate only for clients who can afford legal advice. 

    Small and mid-size companies interested in creating a non-qualified deferred compensation plan should consider the following issues and plan features. (See Figure 1.)

    Figure 1

    Comparison of Plan Features 

     

    Ability to Discriminate

    Contribution Limits

    Subject to Employer Creditors

    Flexible Vesting Schedule

    Qualified Deferred Compensation Plans

    No

    Yes

    No

    No

    Non-qualified Deferred Compensation Plans

    Yes

    No

    Yes

    Yes

    Bonus Plans

    Yes

    No

    No

    Cash: No

    Property: Yes

    1) Put it in writing. In addition to being legally required, this is good business practice and money well spent by the client. What good is an employee benefit plan if the parties are unable to read or understand it? Until the government provides a prototype or safe-harbor plan document, drafting the plan will require the assistance of a lawyer who is familiar with non-qualified benefits. Note that many of the section 409A requirements must be included in the plan document and are not limited to the actual handling of the plan by the parties.

    2) Put someone in charge. Even a perfectly drafted plan presents legal and tax risks if its terms are not reviewed regularly and implemented properly. It may be best to use a third party for plan administration (especially if large deferrals are involved), such as an accounting firm with section 409A experience or one of the growing number of non-qualified benefit administrators that serve this niche.

    3) Limit the plan to employer deferrals. In theory, these plans can include both employer and elective employee deferrals of existing compensation. However, because section 409A penalizes employees who fail to make elective deferrals of compensation at the proper time, it is safer and administratively more convenient to structure the deferral as an extra benefit from the employer. This design eliminates a step, because no election is required of anyone, and should be easily accomplished, because employees of small businesses will be reluctant to subject current salary to claims of the employer’s creditors, tax benefits notwithstanding. Furthermore, there is no legal requirement that employers use contributions to actually fund the plan. The plan merely represents a naked promise by the employer to pay amounts in the future from its general funds.

    4) Limit the number of payout events. Section 409A and its regulations allow payouts only for certain events, such as a defined date, retirement, separation from service, death, disability, unforeseeable emergency, and change of control of the business. Limiting the number of payout events under the plan reduces the likelihood of an inadvertent payment being made.

    5) Consider avoiding section 409A altogether. The final regulations generally exempt from section 409A any plan that requires a lump-sum payment to the employee to be made within two-and-a-half months after the end of the taxable year in which the employee vests. A “paid when vested” plan typically advances the employer’s business objectives and has the additional advantage of totally avoiding section 409A, including the annual information reporting to the IRS. An employer also could consider using the other arrangements described in this article in lieu of non-qualified deferred compensation.

    6) Have an exit strategy. If the plan permits, an employer can terminate the plan at any time with an accompanying payment of vested amounts to the employee. Generally, the payment(s) must occur between 12 months and 24 months following the termination. A three-year waiting period applies before an employee may participate in another similar plan.

    7) Consider the accounting treatment of the plan. The establishment of a non-qualified deferred compensation plan creates a liability on the books of the sponsoring business. This liability may be problematic if the business relies on commercial credit, requires bonding, or might be sold.

    8) Be clear who you represent. The conflict of interest between employer and employee should be apparent to any lawyer retained for benefit planning and may affect the nature of subsequent advice. For example, a lawyer representing the employee should try to negotiate an indemnification clause in the plan that would cover a compliance failure leading to income acceleration, interest, or penalties.

    Supplemental Insurance Plans

    Large companies often provide more generous health insurance coverage to key employees than to the rank and file. Small companies can do the same. Income tax-free health insurance benefits can be provided for key employees, including owner-employees, on a discriminatory basis. The premium currently is deductible to the employer and is excludible from the key employee’s income under I.R.C. § 106. However, a health benefit that is discriminatory, self-insured, and promised to be paid in the future (for example, after retirement) is subject to the section 409A deferred compensation rules described above.

    Another benefit to consider is employer-paid long-term care insurance for key employees age 50 or older. Long-term care insurance for these employees may offer significant financial benefits by funding costs of nursing-home, assisted-living, or at-home care during retirement. The premiums for an employer-sponsored long-term care insurance plan generally are excluded from employee income the same way as health insurance premiums are, except that premiums paid on policies for self-employed persons (and certain close relatives) are subject to age-based and inflation-indexed deductibility limits under I.R.C. § 213(d). As with health insurance, the benefits are income tax-free when received by or on behalf of the insured employee.

    Disability insurance also can be bought by companies on a discriminatory basis for key employees. The tax treatment depends on how the arrangement is structured. For a bonus plan, the business deducts each premium when paid and the employee is currently taxed on it. Under this scenario, the disability benefit payments are income tax-free under I.R.C. § 105 when received from the insurance company. Alternatively, the plan can provide to the employee tax-free premiums (still currently deductible to the employer) that result in taxable disability-benefit payments later on. Under Revenue Ruling 2004-55, an employer may structure a plan that allows an employee to choose from year to year whether the premium will be taxed up-front, provided the employee makes the election before the beginning of the plan year in which the election becomes effective.

    The use of life insurance as a non-qualified benefit is a complex subject; suffice it to say that life insurance can be a part of bonus, deferred compensation, “split dollar,” or other financing arrangements, and other arrangements used by small and large businesses alike. Individually underwritten term or permanent insurance on key employees can supplement or replace the limited amount of insurance provided under qualified group term or cafeteria plans. Permanent insurance has the unique advantage of being the only financial vehicle that can provide tax-deferred cash buildup and a tax-free death benefit at the business level (with certain alternative minimum tax exceptions for C corporations) and offers the usual income tax advantages if owned by the individual employee. Under I.R.C. § 101(j), employees must meet certain criteria and receive notice of and consent to the purchase for the proceeds of any business-owned life insurance issued after Aug. 17, 2006, to be income tax-free. Although insurance companies may help the employer comply with these rules when the policy is applied for, the legal responsibility for complying rests with the employer.

    Smaller Fringe Benefits

    Employers can provide lower-cost fringe benefits that virtually any employee would appreciate receiving, such as free parking and retirement planning services. Under I.R.C. § 132 these benefits generally are taxable to the employee unless they are provided on a nondiscriminatory basis or fall within statutory limits. Nevertheless, an employer can provide certain tax-free reimbursements at a higher dollar value for some employees than for others based on the employees’ working conditions. For example, an executive with regional duties requiring travel could be reimbursed for nonstop airline flights, while reimbursements for lower-level employees without these duties could be limited to the lowest available fare. For more information on the taxation of fringe benefits, see IRS Publication 525 at www.irs.gov.

    Conclusion

    Competitive – and increasingly global – pressures have spawned performance-based compensation structures that reward certain individuals more generously than others. By implementing the techniques described above, lawyers can provide immediate value to business clients by helping them meet these challenges. For any of the described arrangements to work, the dollar amounts involved must be adequate to change employee behavior and align with performance measurements that improve the employer’s bottom line.




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